Innovation and Intellectual Property Rights

Compatibility, interoperability, and market power in upgrade markets by J. Anton and G. Biglaiser (2010, Economics of Innovation and New Technology).

The authors examine the market power of a seller who repeatedly offers upgraded versions of a product. In the case of pure monopoly, the seller also controls compatibility across versions. In the case of an entrant who offers an upgrade, the incumbent seller also controls subsequent interoperability across versions. The paper argues that control of compatibility and interoperability does not allow an incumbent seller to charge a price premium relative to when such control is absent and, consequently, neither is a necessary source of market power.

Quality, Upgrades and Equilibrium in a Dynamic Monopoly Market by J. Anton and G. Biglaiser (2010).

This interesting paper examines an infinite horizon model of quality growth in a durable goods monopoly market. The monopolist generates new quality improvements over time and can sell any available qualities, in any desired bundles, at each point in time. Consumers are identical and for a quality improvement to have value the buyer must possess previous qualities: goods are upgrades. The paper shows that subgame perfect equilibrium payoffs for the seller range from capturing the full social surplus all the way down to capturing only the current flow value of each good and that each of these payoffs is realized in a Markov perfect equilibrium that follows the socially efficient allocation path. This is true for all discount factors. We also show that inefficient equilibria exist for rates of innovation above a threshold.

Uncertainty and Competition in the Adoption of Complementary Technologies by A. Azevedo and D. Paxson (2009).

This paper studies, for a duopoly market, the combined effect of uncertainty, competition and “technological complementarity” on firms’ investment behaviour for a game-choice setting where it is assumed that there is a first-mover advantage. Firms do often use inputs whose qualities are complements such as computer and modem, equipment and structure, train and track, and transmitter and receiver and, therefore, on such cases, investment decisions on upgrades or replacements must consider the degree of complementarity between investments.

The authors derive analytical or quasi-analytical solutions for the leader and the follower value functions and their respective investment thresholds. At the beginning of the investment game firms have two technologies available, whose functions are complement, and the option to adopt both technologies at the same time or at different times, in a context where the evolution of the gains that can be made through the adoption of the technology(ies) and the price of the technologies are uncertain.

The results contradict the conventional wisdom which says that “when a production process requires two extremely complementary inputs, a firm should upgrade (or replace) them simultaneously”. We found that when uncertainty about revenues and the price of the two technologies is considered it might be optimal for the leader and the follower to adopt the two technologies asynchronously, first, the technology whose price is decreasing at a lower rate and then the technology whose price is decreasing more rapidly. Some of the illustrated results show nonlinear and complex investment criteria and sensitivities to the expected rate of change in the price of the technologies and the degree of complementarity between the two technologies.

How to Motivate Innovation: Subsidies or Prizes? by Q. Fuy, J. Luz and Y. Lux (2009).

This paper investigates the optimal design of research contests. A “principal”, who values an innovative technology, attempts to speed up the discovery. In order to minimize the expected amount of innovation time required, the principal decides how to allocate the fixed budget between a top-up prize (e.g. a procurement contract) and efficiency-enhancing subsidies (e.g. research grants) to competing R&D firms. The paper shows that although both subsidies and prize incentives facilitate success, their functions differ subtly and the ability of one to substitute the other is limited. The main results are as follows. Firstly, the optimal contest preferentially subsidizes the ex ante less efficient firm. Secondly, more resources are devoted to research subsidies when the private benefit of the innovation to the successful innovator increases. Finally, more resources are allocated as subsidies when the innovation process involves more uncertainty.

Patents in a Model of Growth with Persistent Leadership by C. Kiedaisch (2009).

This paper analyzes the e¤ects of patent policies in a quality - ladder model of growth where incumbent …rms preemptively innovate in order to keep their position of leadership. The amount of R&D undertaken by leaders increases if an innovation becomes more valuable to an entrant and policies that make it easier to replace incumbents and to obtain considerable market power right upon entry increase growth. I show that making patent policies conditional on whether an innovation is made by an entrant or an incumbent can increase growth and also analyze the e¤ects of conditioning the strength of patent protecion on the size of the lead. In certain cases, an intermediate probabiltiy of patent enforcement leads to the highest average rate of growth.

Efficiency of Cournot and Bertrand competition with cooperative R&D by J. Hinloopen and J. Vandekerckhove (2009)

The authors consider the efficiency of Cournot and Bertrand competition when firms cooperatively conduct cost-reducing R&D. They decompose the combined profits externality into three components: a strategic component, a size component, and a spillover component. The latter bears an opposite sign across competition types. Hence, under Bertrand competition the minimum spillover above which cooperative R&D exceeds noncooperative R&D is higher than under Cournot competition. Also, the traditional difference in R&D investment incentives between Cournot and Bertrand competition is exemplified if firms conduct R&D cooperatively. The Cournot-Nash price can then be below the Bertrand-Nash price, especially if spillovers are strong.

Dynamic efficiency of Cournot and Bertrand competition: input versus output spillovers by J. Hinloopen and J. Vandekerckhove (2009)

This paper considers the efficiency of Cournot and Bertrand equilibria in a duopoly with substitutable goods where firms invest in process R&D that generates input spillovers. Under Cournot competition firms always invest more in R&D than under Bertrand competition. More importantly, Cournot competition yields lower prices than Bertrand competition when the R&D production process is efficient, when spillovers are substantial, and when goods are not too differentiated. The range of cases for which total surplus under Cournot competition exceeds that under Bertrand competition is even larger as competition over quantities always yields the largest producers’ surplus.

Persistence of Monopolies and Research Specialization by P. Weinschenk (2008).

This article examines the persistence of monopolies in markets with innovations when the outcome of research is uncertain. It shows that for low success probabilities of research, the incumbent can seldom preempt the potential entrant. Then the efficiency effect outweighs the replacement effect. It is vice versa for high probabilities. Moreover, the incumbent specializes in “safe” research and the potential entrant in “risky” research. The article also shows that the probability of entry is an inverted U-shape in the success probability. Since even at the peak entry is rather unlikely, the persistence of the monopoly is high.

Innovation by Leaders without Winner-take-all by R. De Bondt and J. Vandekerckhove (2008) and Asymmetric Spillovers and Sequential Strategic Investments by J. Vanderkerckhove and R. De Bondt (2008, Economics of Innovation and New Technology)

This is an interesting paper which provides an interesting analysis of the incentives to invest in R&D for market leaders and followers under exogenous and endogenous entry in patent races, in the presence of spillovers from the innovating firms to the others. More precisely the paper overturn under certain conditions two well established results: the first (Reinganum, 1985) that leaders invest less than the followers under exogenous entry, and the second (Etro, 2004) that leaders invest more under endogenous entry. The first result is overturned when followers must share the fruits of their innovations in case of innovation by a follower. The second one when the leader must share the fruits of its innovation in case of innovation by the leader.

Persistence of Monopoly, Innovation, and R&D Spillovers: Static versus Dynamic Analysis by K. Zigic et al. (2007).

How good are monopolies for conducting innovation? Whether and when these innovations lead to persistence of monopoly? This kind of questions is not exactly new among economists, but they seem to be actual again judging by provocatively entitled ''Slackers or Pace-Setters: monopolies may have more incentives to innovate than economists have thought'' in the celebrated rubric ''Economics Focus'' of the May 2004 issue of “The Economist”. Apparently, there is a controversial role of market power and monopolies in creating innovations and the key to the answer lies in the underlying incentives to undertake innovations. The recent empirical evidence seems to support these Schumpeterian allegations from ''The Economist'' in a sense that there is a positive relationship between market power and intensity of innovation. Moreover, this evidence is, in fact, consistent with pre-emptive, strategic R&D investment by the leaders. As a consequence of such strategic behavior, there may be only one firm that survives in the market in the long run, but then this firm would display far more competitive behavior than standard monopolist. It would respectively generate higher flow of R&D, charge lower price and produce more.

There are many real-world examples of monopolistic or dominant firms that invest more in innovation and R&D than their rivals and that persists over long period of time. Here we could, for instance, mention AT&T as an example of such pattern. Founded in 1885, the company is one of the largest telephone companies and cable television operators in the world. After becoming a first long distance telephone network in the US, AT&T made huge investments in research and development. As a result, the company obtained near monopoly power on long distance phone services. Heavy investments in R&D together with aggressive behavior on the market allowed AT&T to obtain crucial inventions and to spread its near monopoly power on other markets. The company was also buying patents for significant innovations. Only after a suit against AT&T in 1982 followed by the breakup of the company into several local independent units called ''Baby Bells'' in 1984 the US telephone industry became competitive and other companies entered the market. While loosing part of its market power on the long distance telephone services, the company has continued its aggressive investments in R&D. For example, in 2004 AT&T introduced a facility allowing businesses to securely run their private networks without any interruptions on AT&T's leading global Internet Protocol network. This innovation assures the company to remain a leader in IP networking. Even AT&T characterizes itself as ''backed by the research and development capabilities of AT&T labs, the company is a global leader in local, long distance, Internet and transaction-based voice and data services''.

The above observations concerning the relation between innovativeness, leadership and market power motivate this analysis which aims to describe and analyze a particular setup in which the persistence of monopoly can arise in the long run. More specifically, this paper studies the situation in which the market leader undertakes pre-emptive R&D investment, (or, in other words, adopts ''strategic predation'' strategy) that eventually leads to exit of the follower firm or/and prevents or limits the entry of the new firms and we contrast this situation with the one in which the leader (within the same setup) ''accommodates'' the follower, that is, it co-exists with follower in a duopoly market structure. This comparison will enable to study both positive aspects of the two main strategies - accommodation and strategic predation - (like, for instance, which strategy yields higher R&D intensity or R&D stock) and normative aspect (social welfare implications) of the two resulting market structures - duopoly versus (constrained) monopoly.

The novel feature of this approach is in the introduction of an explicit dynamic model and in its contrast with its static (or quasi-dynamic) counterpart. Since strategic innovations are inherently dynamic phenomenon, the authors argue that suitable models aimed at capturing both accommodating and the pre-emptive or predatory behavior of the dominant firm should be explicitly dynamic. Furthermore, to emphasize the role of the leader they assume that the leader is the only one that invests in innovation while the follower imitates through R&D spillovers. (The importance of R&D spillovers, imitations and its economic implications is well and broadly documented in both theoretical and empirical literature). However, most of the theoretical models are static in nature and they focus on the accommodation strategies. That is, strategic predation is simply ignored or precluded by assumptions (so that it is never optimal). In such situations unilateral R&D spillovers create disincentives to invest in R&D and consequently hamper innovations. However, in the case when strategic predation is optimal, the economic implication of R&D spillovers is exactly opposite. They enhance the incentive to invest in R&D.

The paper demonstrates that contrary to the static set-up where (constrained) monopoly is usually marginal market structure (and is therefore often excluded from the analysis by assumption), in the dynamic setup, this market structure becomes more prevalent as the speed of adoption of the new technology increases and the efficiency of R&D process is high. Put together, these two facts yield a testable prediction in that the most propulsive innovative firms, that commercialize their investment in innovation quickly and efficiently (like, say AT&T, Microsoft, etc.), are the ones likely to use the strategic predation through investing large sums of money into innovative activity that in turn, help them to attain monopoly or near monopoly position. As for the social welfare considerations, strategic predation as dominant market strategy is socially preferable as well since it leads to both higher consumer surplus, and to higher social welfare generated despite the fact that only one firm (the leader) remains in the market in the long run. This all bears important competition policy implications. First, the size of market share per se might not be sufficient condition for a legal offence and second the monopoly pricing and consumer protection, that is a usual concern of the competition and antitrust policy, is not an issue in the above setup. The leader threatened by potential (re)entry of the follower keeps price at the notably lower level than the monopoly price.

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Excess Absorptive Capacity and the Persistence of Monopoly by L. Wiethaus (2006).

In high-tech industries the persistence of dominant, monopolistic firms can be explained by superior innovative performance of the monopolist relative to a potential entrant. Superior performance, in turn, follows greater incentives to invest in new products or processes. Accordingly, market structure in high-tech industries is tied to the question whether it is the incumbent or the entrant who has greater incentives to innovate. As a possible explanation, this paper considers how an incumbent’s precommitment to imitate preserves its dominant position. The idea is based on the fact that innovations, in general, are subject to knowledge spillovers for which the recipient needs to have absorptive capacity, i.e. the ability to identify, assimilate, and exploit knowledge from the environment and to apply it to commercial ends. A precommitment to imitate constitutes a credible (counter-)threat to the entrant’s innovative threat.

To illustrate the idea of excess absorptive capacity, consider Microsoft’s reaction to Netscape’s competitive threat. Case evidence provided by Klein (2001) suggests that Microsoft’s browser, Internet Explorer, was clearly inferior to Netscape’s Navigator during 1995-96. But "during 1995-97, Microsoft devoted more than $ 100 million per year to browser software development", and in September 1997 Microsoft achieved superiority in internet browser technology with the release of Internet Explorer 4.0. Apparently Microsoft not only possessed the absorptive capacity to catch up with the progress in browser technology but also had stronger investment incentives to develop the superior and hence eventually successful browser - Microsoft’s success in the battle with Netscape has been primarily related to its aggressive (zero) pricing of Internet Explorer and its tying of Internet Explorer to Windows; Klein (2001), however, reports that it was not before Microsoft had a comparable product available until Internet Explorer’s usage began to increase. In light of the initially cited theories on incentives to innovate, Microsoft’s massive investments are indeed surprising (Arrow’s replacement effect might have arguably been strong due to Microsoft’s comfortable returns from Windows whereas Netscape possessed the initial technological advantage, which theoretically suggests less investments by the incumbent Microsoft).

How does excess absorptive capacity help to explain this investment behavior? The paper shows that absorptive capacity reduces the entrant’s innovation investments and has two effects on the incumbent’s investments. On the one hand it induces an aggressive innovation effect: deterring the entrant’s innovation efforts increases the profitability of the incumbent’s investments. On the other hand excess absorptive capacity creates a copycat effect, countervailing the former: an incumbent reduces its own innovation efforts to free ride on a successful innovation by the entrant. The copycat effect vanishes if profits in post-innovation competition approach zero (i.e. Bertrand competition). Then the aggressive innovation effect might indeed be sufficiently strong to guarantee more innovation efforts by the incumbent, even when traditional theories would suggest otherwise. These findings are consistent with the (scarce) empirical evidence on innovation behavior by incumbents and entrants (which find a positive relationship between innovation and market share, to reflect incumbency, as well as between innovation and a firm’s knowledge stock).

On this see also Business Strategies Towards the Creation, Absoprption and Dissemination of New Technologies by L. Wiethaus (2005, PhD Dissertation, Universität Hamburg)